Venture Capital Alphabet
Here at Megamind we often write about startups and their financing, in connection with which some users may have justified terminological questions. In almost every article on investing in startups, you can read the phrase: “SuperMegaStartup raised $ dofig million at stage A” . Of course, for many this phrase is quite understandable and natural for itself, but when the conversation goes to the letters B, C, D and beyond, many begin to swim, at best getting off with common phrases. In this article I will try to clarify everything and eliminate this annoying defect.
In general, venture capital investment is bidirectional. On the one hand, it involves raising third-party capital to develop, improve, launch and expand the company. On the other hand, a high-risk investment is expected in order to obtain super-profits. The venture financing process, as a rule, is carried out in stages, and the process structure is quite flexible and does not require the mandatory implementation of all classified investment rounds.
According to accepted terminology, the following stages of venture financing are distinguished:
Sowing stage (seed round)
"Sowing" is the first stage of venture financing. At this level, as a rule, relatively modest amounts of capital are provided to inventors or entrepreneurs to finance the early development of a new product or service. Funds of this level can be used to pay for preliminary operations for product development, market research, the formation of a team of managers and the development of a business plan.
Seed capital, being in some way a form of securities, involves the acquisition by an investor of part of a new business. The term "sowing" appeared by analogy and describes the earliest investments intended to "support the pants" of a business until it can generate its own cash flows or until further investments are initiated. Capital at this level includes options for using funds from friends, family, business angels, and crowdfunding.
Initial financing is the most risky, because the investor does not see a materialized product and has only background assessments of the implementation of the financing project.
In the USA, the seed capital invested by a professional venture company, as a rule, does not exceed $ 1 million.
Seed venture capital funds participate in later rounds of investment along with other players financing the costs of developing and expanding the business.
We owe this term to William Wetzel, a professor at the University of New Hampshire, who published a study in 1978 in which he described venture capital investors, by analogy with patrons of Broadway theater productions.
This level of financing is sometimes combined with seed if seed investments were received from business angels. Accordingly, the above description of seed investments regarding venture capitalists is valid for this round of financing. If the angelic round is separated from the seed, at this level investments are offered in return for the company's ordinary shares.
A feature of angel investing is that in addition to money, assistance is offered in the organization, management and proper distribution of these funds. Many angels have such undocumented opportunities, in comparison with which their investment of money can be a small service.
Letter rounds of investments
Series A is usually the first significant round of venture financing. The name reflects the exchange of preferred shares for investment funds. Attracted capital is spent on income growth and profit generation, expansion and financing. A Series investments are required for speedy development and growth. Most often, competitors are activated during this period, and there is also the possibility of capturing a significant part of the market.
Preferred shares of this round are distributed to participants in seed and early investments. These shares are often converted to ordinary shares in the event of a company sale or IPO.
Series A is traditionally an important stage in financing startups. A typical round of this series attracts funds ranging from $ 2 to $ 10 million for 10-30 percent of the company's shares. The capital attracted at this time is intended to capitalize the company for a period of 6 months to 2 years, while the company develops its product, carries out primary marketing and branding, hires its first employees, and also completes operations that were not completed in the early stages of the business.
The sources of capital for the A series are most often venture capital funds and private individuals, and investors and entrepreneurs intersect through various conferences and demo days, as young companies are not public and information about them is not published in financial publications.
In fairness, it is worth noting the fact that all rounds of investments are most often mixed investments, including funds from angelic, institutional and private investors, as well as collected on crowdfunding platforms.
The investment structure of the A series involves spending smaller investment packages on attracting and making large investments, financial expenses to serve new investors, and analysis and audit by institutional investors. Thus, companies that need operating funds and are not prepared for large venture capital investments are trying to attract angel capital. At this stage, attracting large investment packages is not only unreasonable, but also practically disastrous for a fledgling business.
Typically, A Series investments in the technology sector are widely covered in the business press, blogs, industry reports, and other media. In other sectors, this round of venture capital investments occurs in a similar way, on the same legal and financial principles, differing mainly in specific industry terminology.
Depending on the needs and capabilities of the company, Series A can advance the company to the point where it can operate with its own cash flows.
Series "B" involves investments spent on the development and growth of the business. Most often, this refers to the transfer of a company's business model to new markets.
In general, all the letter rounds of investments completely differ only in the type of securities offered; in terms of functions and cost structure, rounds may have similar characteristics. Accordingly, the letter of the round and paper differ. So the first round of financing the company includes the issuance of preferred securities of series “A”, the second round - securities of series “B” and so on. Most startups do not go beyond the investment series “C” or “D”. The papers of each series have different values.
When it is not possible to achieve the objectives of the investment round, the company moves on to the next, but investors should be aware that later rounds have less profitability. Entrepreneurs, in turn, need to remember the possibility of diluting the company's capital and losing control.
Also, later episodes may indicate that the company is not developing as expected. In this case, investors may worry that the company has spent too many rounds of raising funds, considering this a sign of stagnation.
Series A, B, ... Sometimes, companies require additional funds at the current stage of investment. In order not to start a new round, entrepreneurs are trying to recapitalize the company on the same conditions.
It happens that the series “AA”, “BB” are also distinguished ... Today, it is customary to allocate the investments of these rounds as preliminary ones to the corresponding rounds according to the letter. The AA series is sometimes even called seed investments, which in my opinion does not at all reflect its essence. The AA series is used to support less capital-intensive business growth and is characterized by simplified procedures and low legal costs, which, in turn, cannot fail to attract early investors and founders.
Some distinguish still intermediate rounds of investments, but their implementation is a rather rare and controversial event. These rounds involve raising funds that provide increased investment income, but have the lowest repayment priority.
The topic of venture today is one of the most popular and interesting, as it is undergoing yet another rebirth. At the same time, there is a certain difficulty in studying the processes of the venture capital market, which consists in the absence of a single theoretical and methodological approach to venture capital investment.
Since the venture capital market originated and gained the greatest development in the United States, we are forced to put up with the existing terminology. At the same time, it is typical that the American system of venture investments differs from both the European and ours, and is based on a continuous cycle of financing (the main task of the venture market is to accumulate funds and place them). From the American point of view, the concept of venture capital invests high-risk capital at the "seed" and "initial" stages of development. The European approach (as well as the Russian one) supplements venture capital with investments in the late stages of development. Another feature of domestic venture capitalism is the formation of venture and direct investment funds for a specific project, often promoted by the state.
According to the Dow Jones VentureSource studies described on the Vedomosti website , American venture capitalists are more generous than European ones: if seed investments are approximately the same on both sides of the Atlantic, then in the next round of investment, startups in the United States get about twice as much as in Europe not to mention subsequent rounds.
Why these difficulties with the separation of investment packages and the distribution of funds? Isn’t it easier to invest to the fullest at once?
No, not easier. Have you ever tried to swallow a whole watermelon? So here, a young company needs a gradual investment to transform its business processes. Each investment package should arrive no earlier and no later than necessary, otherwise there is a great risk of ruining the company.